Risk and the Corporate Structure of Banks

In our paper Risk and the Corporate Structure of Banks, which was recently accepted for publication in the Journal of Finance, we analyze how risk affects the organizational structure of banks’ foreign operations. Our primary focus is on a bank’s decision to set up affiliates as either subsidiaries or as branches. Subsidiaries are locally incorporated stand-alone entities endowed with their own capital and protected by limited liability at the affiliate level. In other words, they are foreign-owned local banks for which the parent bank’s legal obligation is limited to the capital invested. By contrast, branches are merely offices of the parent bank without an independent legal personality. As such, the liabilities of branch affiliates represent real claims on the parent bank. Therefore, the decision to enter as either a subsidiary or a branch has important implications for the parent bank’s risk exposure.

We focus on two different, albeit related, sources of risk. First, banks are subject to credit or economic risk in the host market. Some of this risk can arise as a result of changes in macroeconomic conditions as shocks to economic activity and interest rates affect the credit worthiness of borrowers and may lead them to default on their loans, making the affiliate’s revenue uncertain. Second, host governments may engage in policies that infringe on the bank’s property rights and expropriate either fully or partially the bank’s revenue and capital. Such actions may entail direct expropriation, but extend to other policies including discretionary taxation, capital controls on repatriated profits, the redirecting of business toward state-owned or favored institutions, or forcing banks to hold government debt.

Figure 1 in our paper displays a negative relationship between the relative importance of economic versus political risk and the proportion of foreign affiliates organized as branches. The model we present explains this pattern and analyzes the implications of risk on banks’ organizational form. Furthermore, we show that banks’ corporate structures have implications for their entry decisions and their scale of entry, as well as for their risk-management practices. In our model, a bank that is active across multiple markets can organize its affiliate operations as either branches or subsidiaries. These affiliates are exposed to the two sources of risk discussed above, namely political and economic risk. We assume that subsidiaries are protected by limited liability at the affiliate level, whereas for branches limited liability applies at the consolidated (parent) bank level. Banks are also subject to minimum capital requirements that in the case of subsidiaries need to be met at the affiliate level, while for the branch structure can be satisfied on a consolidated basis.

We identify an important trade-off for how banks choose their corporate structure between the stronger limited liability protection offered by a subsidiary structure and the greater protection against property right infringements offered by the branch structure. We show that when political risks are the prevalent source of uncertainty, a branch-based structure is preferable as it keeps capital with the parent bank, thus shielding it from expropriation by the foreign government. However, when credit risk is more prevalent and of greater consequence, the limited liability of a subsidiary-based structure provides the bank with greater protection since it shields the parent company from losses that might spill over onto its balance sheet.

The main contribution of this paper is to identify different sources of risk as important determinants of a bank’s corporate structure. We show that the form of a bank’s expansion into new markets is influenced by the types of risks to which the bank will be exposed. Banks can take measures to reduce the effect of risk and to minimize the impact of losses, preserving their capital by their choice of corporate structure. The corporate structure thus becomes a function of the type of risk that is most relevant, with banks designing their organizational form to reduce the inefficiencies introduced by expropriation and to better deal with the economic risks they face. Our results contribute to the recent policy discussion concerning banks’ limited use of the EU’s “single passport” for bank entry, despite the ease of its use.

The full paper is available for download at here.